Oversold China catches the eye of investors

, July 28, 2013

By Gertrude Chavez-Dreyfuss

A slowdown in China has hit its financial markets hard this year as fund managers cut exposure to the world's second largest economy, but some investors say it may be time to jump back in.

The country's downturn is being felt around the world. Energy and materials stocks have been hit, commodities prices are lower, and the currencies of China's trading partners, including Australia, Taiwan and South Korea, have tumbled.

The index of the leading Shanghai and Shenzhen A-shares - the CSI300 - was down 11.8 percent this year, while the Shanghai Composite Index slumped 11.4 percent. Lipper data shows five straight months of outflows from China equity-focused funds.

A recent Bank of America-Merrill Lynch survey lists a China slowdown as the biggest worry among big fund managers. On Friday, China's industry ministry ordered companies across 19 industries to close outdated capacity by the end of September.

But some investors believe the selloff is nearing an end as officials take steps to boost demand.

"China has become one of the cheapest in Asia for an economy that has $6 trillion in national savings and a fraction of the debt that developed countries have," said Joe Portelli, chief investment officer at FMG in Malta, with assets of about $200 million invested exclusively in emerging and frontier markets.

Portelli said China's price-to-earnings multiple is 10, much lower than the S&P 500's P/E ratio of 15 and the historic P/E ratio for Chinese stocks in the mid-20s.

FMG's China Fund invests in China's A shares listed on the CSI300 index. It is down about 3.8 percent so far this year.

Portelli, whose firm has a three-to-five-year investment horizon, said that if the CSI300 falls below 2,100 points for an extended period, FMG would convert some of its holdings into cash. The index closed Friday at 2,224 points.

"The fact that China isn't growing at double digits is not material for us," Portelli said. "We believe our clients should have exposure to a country that is the second largest or has the potential to become the largest in the world."

Chinese Premier Li Keqiang suggested this year's official GDP growth target is 7.5 percent, and growth below 7 percent would not be tolerated, so China could engage in some fiscal expansion that should ease "hard landing" fears.

"We're comfortable with China growing between 7.0-7.5 percent, and we approve the small actions taken by the government to target a more sustainable growth," said Andrew Wilson, the London-based chief executive of Goldman Sachs Asset Management International.

However, Goldman, which oversees more than $500 billion in assets, has taken a short position on the Chinese yuan's non-deliverable forwards on the expectation that the currency will soften due to China's slowdown, Wilson said.

Non-deliverable forwards are used by investors to bet on currencies such as the yuan in which the government has strict exchange controls. The Chinese yuan last traded at 6.1316 against the dollar, up 1.5 percent on the year.

The Chinese government recently removed the floor that previously applied to lending rates China's financial institutions could offer their customers. It also urged local governments to spend more money to boost growth.

Bill Sung, chief investment officer at Absolute Asia Asset Management in Singapore, said if economic reforms to move China to a more consumer-based economy are successful, "China should emerge stronger over the longer term."

The firm has temporarily lowered its China weighting, mainly due to the higher volatility arising from expectations that the Federal Reserve will reduce its stimulus program.

PRICING THE SLOWDOWN

So far in 2013, $3.65 billion has been withdrawn from China equity funds, according to Lipper, a Thomson Reuters company.

The sell-off has driven down China's Hong Kong-listed H shares. The China Enterprise Index is down 14.7 percent in 2013 and was last at 9,757.58 points. The index hit a low of 8,640 in late June.

Chinese H shares are currently trading at a P/E ratio of 8.2, not far from their trough of 7.1 hit in the late 1990s and in 2008, according to Societe Generale. Vivek Misra, the firm's Asia equity strategist in Mumbai, said investors should consider buying H shares when the HSCE index hits the 8,000 level.

"At 8,000, the P/E ratio would be 6.95 in a market where analysts expect earnings per share to grow at a compounded annual rate of 11 percent the next three years," Misra said.

There are bargains as well, with the Chinese materials and financials sectors oversold by about 25 percent and 9 percent, respectively, Bank of America Merrill Lynch data show.

Investors such as Aberdeen Asset Management in Aberdeen, Scotland, which has more than $300 billion under management, remain cautious on China due to lower corporate profits and tighter credit policies. The firm is using investments in Hong Kong as a way of remaining exposed to the economy, but with some protection.

Hong Kong is not immune to China's downturn, although the Hang Seng Index has only lost 3.3 percent this year.

Nicholas Yeo, Aberdeen's head of China and Hong Kong equities, said companies in Hong Kong have stronger balance sheets and are more resilient during downturns "compared to the relatively young and inexperienced mainland Chinese companies."

Aberdeen invests 70 percent of its China fund in Hong Kong and 30 percent in China. For the year until July 25, Aberdeen's Greater China Fund was down 10.5 percent.

Over the longer term, however, Yeo was not too worried about China, saying, "Slower growth is a necessary precondition for a clean-up of the financial system ... and the state's financial resources are considerable and can deal with the problem.” – Reuters